I need discussion/talk about chapter 3 no less than 2, discussion/talk for each chapter and no less than 100 words for each discussion/talk, will ask to change word count at any time. Discuss/talk about what was interesting about chapter, summary of chapter or any kind of discussion from chapter. Due in 24 hours or less.
Ch3
Corporate managers must issue many reports to the public. Most stockholders, analysts, government entities, and other interested parties pay particular attention to annual reports. An annual report provides four basic financial statements: the balance sheet, the income statement, the statement of cash flows, and the statement of retained earnings. A financial statement provides an accounting-based picture of a firm’s financial position.
Whereas accountants use reports to present a picture of what happened in the past, finance professionals use financial statements to draw inferences about the future. The four statements function to provide key information to managers, who make financial decisions, and to investors, who will accept or reject possible future investments in the firm. When you encountered these four financial statements in accounting classes, you learned how they function to place the right information in the right places. In this chapter, you will see how understanding these statements, which are the “right places” for crucial information, creates a solid base for your understanding of decision-making processes in managerial finance.
Financial statements of publicly traded firms can be found in a number of places. For example, all quarterly and annual financial statements can be found at a firm’s website (often under a section titled “investor relations”). Financial statements of publicly traded companies are reported to the Securities and Exchange Commission (SEC), who makes them publicly available at their website (www.sec.gov); annual reports are listed under the term 10-K, and quarterly financial statements are listed as 10-Qs. Finally, a number of websites exist (e.g., finance.yahoo.com) where one can view and download financial statements of publicly traded companies. Nonpublic firms are not required to submit financial statements to the SEC. Thus, it can be quite difficult to find detailed financial information about these firms. This is one reason why some large firms (Cargill, Toys “R” Us, Fidelity) hesitate to become publicly traded; they prefer to keep their financial statement information private.
It should also be noted that this chapter presents a basic set of financial statements; enough so that, from a financial manager’s viewpoint, we can identify the basic categories on each statement and relationships across statements. Individual firms’ financial statements may look different from those presented in the chapter, depending on the level of detail and accounting methods used. Further, financial statements may be presented in various formats, e.g., in a pdf file or in an Excel spreadsheet. Appendix 2A to the chapter (available in Connect or through your instructor) presents the 2012 financial statements for Colgate-Palmolive Company as listed in its Annual Report, in its 10-K statement, and in an Excel spreadsheet. Note that while the numbers are the same in all formats, the presentation of the numbers can vary greatly.
This chapter examines each statement to clarify its major features and uses. We highlight the differences between the accounting-based (book) value of a firm (reflected in these statements) and the true market value of a firm, which we will come to understand more fully. We also make a clear distinction between accounting-based income and actual cash flows, a topic further explored in Chapter 3, where we see how important cash flows are to the study of finance.
We also open a discussion in this chapter about how firms choose to represent their earnings. We’ll see that managers have substantial discretion in preparing their firms’ financial statements, depending on strategic plans for the organization’s future. This is worth looking into as we keep the discipline of finance grounded in a real-world context. Finally, leading into Chapter 3, we discuss some cautions to bear in mind when reviewing and analyzing financial statements.
Page 23
reviewing
financial statements
LEARNING GOALS
| LG2-1 | Recall the major financial statements that firms must prepare and provide. |
| LG2-2 | Differentiate between book (or accounting) value and market value. |
| LG2-3 | Explain how taxes influence corporate managers’ and investors’ decisions. |
| LG2-4 | Differentiate between accounting income and cash flows. |
| LG2-5 | Demonstrate how to use a firm’s financial statements to calculate its cash flows. |
| LG2-6 | Observe cautions that should be taken when examining financial statements. |
*See Appendix 2A: Various Formats for Financial Statements, available in Connect or through your instructor.
Page 24viewpoints
business APPLICATION
The managers of DPH Tree Farm, Inc., believe the firm could double its sales if it had additional factory space and acreage. If DPH purchased the factory space and acreage in 2016, these new assets would cost $27 million to build and would require an additional $1 million in cash, $5 million in accounts receivable, $6 million in inventory, and $4 million in accounts payable. In addition to accounts payable, DPH Tree Farm would finance the new assets with the sale of a combination of long-term debt (40 percent of the total) and common stock (60 percent of the total). Assuming all else stays constant, what will these changes do to DPH Tree Farm’s 2016 balance sheet assets, liabilities, and equity? (See 2015 balance sheet on p. 26)
BALANCE SHEET LG2-1
The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time. It is a picture of the assets the firm owns and who has claims on these assets as of a given date, for example, December 31, 2015. A firm’s assets must equal (balance) the liabilities and equity used to purchase the assets (hence the term balance sheet):
Figure 2.1 illustrates a basic balance sheet and Table 2.1 presents a simple balance sheet for DPH Tree Farm, Inc., as of December 31, 2015 and 2014. The left side of the balance sheet lists assets of the firm and the right side lists liabilities and equity. Both assets and liabilities are listed in descending order of liquidity , that is, the time and effort needed to convert the accounts to cash. The most liquid assets—called current assets—appear first on the asset side of the balance sheet. The least liquid, called fixed assets, appear last. Similarly, current liabilities—those obligations that the firm must pay within a year—appear first on the right side of the balance sheet. Stockholders’ equity, which never matures, appears last on the balance sheet.
Page 25personal APPLICATION
Chris Ryan is looking to invest in DPH Tree Farm, Inc. Chris has the most recent set of financial statements from DPH Tree Farm’s annual report but is not sure how to read them or what they mean. What are the four financial statements that Chris should pay most attention to? What information will these key financial statements contain?
| Thinking of starting your own business? Learn more . . . Scan the QR code for an extended look. Turn to the back of the book for solutions to these applications. |
Assets
Figure 2.1 shows that assets fall into two major categories: current assets and fixed assets. Current assets will normally convert to cash within one year. They include cash and marketable securities (short-term, low-rate investment securities held by the firm for liquidity purposes), accounts receivable, and inventory. Fixed assets have a useful life exceeding one year. This class of assets includes physical (tangible) assets, such as net plant and equipment, and other, less tangible, long-term assets, such as patents and trademarks. We find the value of net plant and equipment by taking the difference between gross plant and equipment (or the fixed assets’ original value) and the depreciation accumulated against the fixed assets since their purchase. Likewise, other long-term assets would be listed net of amortization.
FIGURE 2.1 The Basic Balance Sheet
Liabilities and Stockholders’ Equity
Lenders provide funds, which become liabilities , to the firm. Liabilities fall into two categories as well: current or long-term. Current liabilities constitute the firm’s obligations due within one year, including accrued wages and taxes, accounts payable, and notes payable. Long-term debt includes long-term loans and bonds with maturities of more than one year.
The difference between total assets and total liabilities of a firm is the stockholders’ (or owners’) equity. The firm’s preferred and common stock owners provide the funds known as stockholders’ equity . Preferred stock is a hybrid security that has characteristics of both long-term debt and common stock. Preferred stock is similar to common stock in that it represents an ownership interest in the issuing firm but, like long-term debt, it pays a fixed periodic (dividend) payment. Preferred stock appears on the balance sheet as the cash proceeds when the firm sells preferred stock in a public offering. Common stock and paid-in surplus is the fundamental ownership claim in a public or private company. The proceeds from common stock and paid-in surplus appear as the other component of stockholders’ equity. If the firm’s managers decide to rein-vest cumulative earnings (recorded on the firm’s income statement) rather than pay the dividends to stockholders, the balance sheet will record these funds as retained earnings .
financial statement Statement that provides an accounting-based picture of a firm’s financial position.
balance sheet The financial statement that reports a firm’s assets, liabilities, and equity at a particular point in time.
liquidity The ease of conversion of an asset into cash at a fair value.
current assets Assets that will normally convert to cash within one year.
marketable securities Short-term, low-rate investment securities held by the firm for liquidity purposes.
fixed assets Assets with a useful life exceeding one year.
liabilities Funds provided by lenders to the firm.
current liabilities Obligations of the firm that are due within one year.
long-term debt Obligations of the firm that are due in more than one year.
stockholders’ equity Funds provided by the firm’s preferred and common stock owners.
preferred stock A hybrid security that has characteristics of both long-term debt and common stock.
common stock and paid-in surplus The fundamental ownership claim in a public or private company.
Page 26TABLE 2.1 Balance Sheet for DPH Tree Farm, Inc.
Managing the Balance Sheet
Managers must monitor a number of issues underlying items reported on their firms’ balance sheets. We examine these issues in detail throughout the text. In this chapter, we briefly introduce them. These issues include:
• The accounting method for fixed asset depreciation.
• The level of net working capital.
• The liquidity position of the firm.
• The method for financing the firm’s assets—equity or debt.
• The difference between the book value reported on the balance sheet and the true market value of the firm.
Accounting Method for Fixed Asset Depreciation Managers can choose the accounting method they use to record depreciation against their fixed assets. Recall from accounting that depreciation is the charge against income that reflects the estimated dollar cost of the firm’s fixed assets. The straight-line method and the MACRS (modified accelerated cost recovery system) are two choices. Companies commonly choose MACRS when computing the firm’s taxes and the straight-line method when reporting income to the firm’s stockholders. The MACRS method accelerates depreciation, which results in higher depreciation expenses and lower taxable income, thus lower taxes, in the early years of a project’s life. Regardless of the depreciation method used, over time both the straight-line and MACRS methods result in the same amount of depreciation and therefore tax (cash) outflows. However, because the MACRS method defers the payment of taxes to later periods, firms often favor it over the straight-line method of depreciation. We discuss this choice further in Chapter 12.
Net Working Capital We arrive at a net working capital figure by taking the difference between a firm’s current assets and current liabilities.
So, clearly, net working capital is positive when the firm has more current assets than current liabilities. Table 2.1 shows the 2015 and 2014 year-end balance sheets for DPH Tree Farm, Inc. At year-end 2015, the firm had $205 million of current assets and $120 million of current liabilities. So the firm’s net working capital was $85 million. A firm needs cash and other liquid assets to pay its bills as expenses come due. As described in more detail in Chapter 14, liability holders monitor net working capital as a measure of a firm’s ability to pay its obligations. Positive net working capital values are usually a sign of a healthy firm.
Liquidity As we noted previously, any firm needs cash and other liquid assets to pay its bills as debts come due. Liquidity actually refers to two dimensions: the ease with which the firm can convert an asset to cash, and the degree to which such a conversion takes place at a fair market value. You can convert Page 27any asset to cash quickly if you price the asset low enough. But clearly, you will wish to convert the asset without giving up a great portion of its value. So a highly liquid asset can be sold quickly at its fair market value. An illiquid asset, on the other hand, cannot be sold quickly unless you reduce the price far below fair value.
Current assets, by definition, remain relatively liquid, including cash and assets that will convert to cash within the next year. Inventory is the least liquid of the current assets. Fixed assets, then, remain relatively illiquid. In the normal course of business, the firm would have no plans to liquefy or convert these tangible assets such as buildings and equipment into cash.
Liquidity presents a double-edged sword on a balance sheet. The more liquid assets a firm holds, the less likely the firm will be to experience financial distress. However, liquid assets generate little or no profits for a firm. For example, cash is the most liquid of all assets, but it earns little, if any, for the firm. In contrast, fixed assets are illiquid, but provide the means to generate revenue. Thus, managers must consider the trade-off between the advantages of liquidity on the balance sheet and the disadvantages of having money sit idle rather than generating profits.
“Positive net working capital values are usually a sign of a healthy firm.”
Debt versus Equity Financing You learned in your high school physics class that levers are very useful and powerful machines—given a long enough lever, you can move almost anything. Financial leverage is likewise very powerful. Leverage in the financial sense refers to the extent to which a firm chooses to finance its ventures or assets by issuing debt securities. The more debt a firm issues as a percentage of its total assets, the greater its financial leverage. We discuss in later chapters why financial leverage can greatly magnify the firm’s gains and losses for the firm’s stockholders.
When a firm issues debt securities—usually bonds—to finance its activities and assets, debt holders usually demand first claim to a fixed amount of the firm’s cash flows. Their claims are fixed because the firm must only pay the interest owed to bond-holders and any principal repayments that come due within any given period. Stockholders—who buy equity securities or stocks—claim any cash flows left after debt holders are paid. When a firm does well, financial leverage increases shareholders’ rewards, since the share of the firm’s profits promised to debt holders is set and predictable.
However, financial leverage also increases risk. Leverage can create the potential for the firm to experience financial distress and even bankruptcy. If the firm has a bad year and cannot make its scheduled debt payments, debt holders can force the firm into bankruptcy. But managers generally prefer to fund firm activities using debt, precisely because they can calculate the cost of doing business without giving away too much of the firm’s value. Managers often walk a fine line as they decide upon the firm’s capital structure —the amount of debt versus equity financing held on the balance sheet—because it can determine whether the firm stays in business or goes bankrupt.
Book Value versus Market Value LG2-2 Beginning finance students usually have already taken accounting, so they are familiar with the accounting point of view. For example, a firm’s balance sheet shows its book (or historical cost) value based on generally accepted accounting principles (GAAP). Under GAAP, assets appear on the balance sheet at what the firm paid for them, regardless of what those assets might be worth today if the firm were to sell them. Inflation and market forces make many assets worth more now than they were worth when the firm bought them. So in many cases, book values differ widely from market values for the same assets—the amount that the assets would fetch if the firm actually sold them. For the firm’s current assets—those that mature within a year—the book value and market value of any particular asset will remain very close. For example, the balance sheet lists cash and marketable securities at their market value. Similarly, firms acquire accounts receivable and inventory and then convert these short-term assets into cash fairly quickly, so the book value of these assets is generally close to their market value.
retained earnings The cumulative earnings the firm has reinvested rather than pay out as dividends.
net working capital The difference between a firm’s current assets and current liabilities.
financial leverage The extent to which debt securities are used by a firm.
capital structure The amount of debt versus equity financing held on the balance sheet.
book (or historical cost) value Assets are listed on the balance sheet at the amount the firm paid for them.
market value Assets are listed at the amount the firm would get if it sold them.
The book value and market value of a classic car can be very different.
Page 28The “book value versus market value” issue really arises when we try to determine how much a firm’s fixed assets are worth. In this case, book value is often very different from market value. For example, if a firm owns land for 100 years, this asset appears on the balance sheet at its historical cost (of 100 years ago). Most likely, the firm would reap a much higher price on the land upon its sale than the historical price would indicate.
Again, accounting tools reflect the past: Balance sheet assets are listed at historical cost. Managers would thus see little relation between the total asset value listed on the balance sheet and the current market value of the firm’s assets. Similarly, the stockholders’ equity listed on the balance sheet generally differs from the true market value of the equity. In this case, the market value may be higher or lower than the value listed on the firm’s accounting books. So financial managers and investors often find that balance sheet values are not always the most relevant numbers. The following example illustrates the difference between the book value and the market value of a firm’s assets.
time out!
2-1 What is a balance sheet?
2-2 Which are the most liquid assets and liabilities on a balance sheet?
INCOME STATEMENT
You will recall that income statements show the total revenues that a firm earns and the total expenses the firm incurs to generate those revenues over a specific period of time, for example, the year 2015. Remember that while the balance sheet reports a firm’s position at a point in time, the income statement reports performance over a period of time, for example, over the last year. Figure 2.2 illustrates a basic income statement and Table 2.2 shows a simple income statement for DPH Tree Farm, Inc., for the years ended December 31, 2015 and 2014. DPH’s revenues (or net sales) appear at the top of the income statement. The income statement then shows various expenses (cost of goods sold, other operating expenses, depreciation, interest, and taxes) subtracted from revenues to arrive at profit or income measures.
income statement Financial statement that reports the total revenues and expenses over a specific period of time.
| EXAMPLE 2-1 | Calculating Book versus Market Value LG2-2 |
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EZ Toy, Inc., lists fixed assets of $25 million on its balance sheet. The firm’s fixed assets were recently appraised at $32 million. EZ Toy, Inc.’s, balance sheet also lists current assets at $10 million. Current assets were appraised at $11 million. Current liabilities’ book and market values stand at $6 million and the firm’s long-term debt is $15 million. Calculate the book and market values of the firm’s stockholders’ equity. Construct the book value and market value balance sheets for EZ Toy, Inc.
SOLUTION:
Recall the balance sheet identity in equation 2-1: Assets = Liabilities + Equity. Rearranging this equation: Equity = Assets − Liabilities. Thus, the balance sheets would appear as follows:
Similar to Problems 2-17, 2-18, self-test problem 2
Page 29The top part of the income statement reports the firm’s operating income. First, we subtract the cost of goods sold (the direct costs of producing the firm’s product) from net sales to get gross profit (so, DPH Tree Farm enjoyed gross profits of $155 million in 2014 and $182 million in 2015). Next, we deduct other operating expenses from gross profits to get earnings before interest, taxes, depreciation, and amortization ( EBITDA ); DPH Tree Farm’s EBITDA was $140 million in 2014 and $165 million in 2015. Other operating expenses include marketing and selling expenses as well as general and administrative expenses. Finally, we subtract depreciation and amortization from EBITDA to get operating profit or earnings before interest and taxes ( EBIT ) (so DPH Tree Farm’s EBIT was $128 million in 2014 and $165 million in 2015). The EBIT figure represents the profit earned from the sale of the product without any financing cost or tax considerations.
The bottom part of the income statement summarizes the firm’s financial and tax structure. First, we subtract interest expense (the cost to service the firm’s debt) from EBIT to get earnings before taxes ( EBT ). So, as we follow our sample income statement, DPH Tree Farm had EBT of $110 million in 2014 and $136 million in 2015. Of course, firms differ in their financial structures and tax situations. These differences can cause two firms with identical operating income to report differing levels of net income. For example, one firm may finance its assets with only debt, while another finances with only common equity. The company with no debt would have no interest expense. Thus, even though EBIT for the two firms is identical, the firm with all-equity financing and no debt would report higher net income. We subtract taxes from EBT to get the last item on the income statement (the “bottom line”), or net income . DPH Tree Farm, Inc., reported net income of $70 million in 2014 and $90 million in 2015.
FIGURE 2.2 The Basic Income Statement
TABLE 2.2 Income Statement for DPH Tree Farm, Inc.
gross profit Net sales minus cost of goods sold.
EBITDA Earnings before interest, taxes, depreciation, and amortization.
EBIT Earnings before interest and taxes.
EBT Earnings before taxes.
net income The bottom line on the income statement.
Page 30Below the net income, or bottom line, on the income statement, firms often report additional information summarizing income and firm value. For example, with its $90 million of net income in 2015, DPH Tree Farm, Inc., paid its preferred stockholders cash dividends of $10 million and its common stockholders cash dividends of $25 million, and added the remaining $55 million to retained earnings. Table 2.1 shows that retained earnings on the balance sheet increased from $155 million in 2014 to $210 million in 2015. Other items reported below the bottom line include:
We discuss these items further in Chapter 3.
Debt versus Equity Financing
As mentioned earlier, when a firm issues debt to finance its assets, it gives the debt holders first claim to a fixed amount of its cash flows. Stockholders are entitled to any residual cash flows, or net income. Thus, when a firm alters its capital structure to include more or less debt (and, in turn, less or more equity), it impacts the residual cash flows available for the stockholders, i.e., the numerator of the EPS equation. Further, as the firm alters its capital structure, it will issue more shares of stock when it increases equity to reduce debt, or it will buy back shares of stock when it decreases equity to increase debt, i.e., the denominator of the EPS equation. Thus, a change in capital structure will cause a firm’s stockholders’ EPS to change. The question is: Will the reduction (increase) in financial distress and bankruptcy risk from the reduction (increase) in financial leverage appease the stockholders who have lost (gained) earnings per share?
| EXAMPLE 2-2 | Impact of Capital Structure on a Firm’s EPS LG2-1 |
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Consider a firm with an EBIT of $750,000. The firm finances its assets with $1,600,000 debt (costing 5 percent) and 200,000 shares of stock selling at $6.00 per share. To reduce the firm’s risk associated with this financial leverage, the firm is considering reducing its debt by $600,000 by selling an additional 100,000 shares of stock. The firm is in the 40 percent tax bracket. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $750,000. Calculate the dilution in the firm’s EPS from this change in capital structure.
SOLUTION:
The EPS before and after this change in capital structure is illustrated below:
The change in capital structure would dilute the stockholders’ EPS by $0.61.
Similar to Problems 2-5, 2-6, 2-23, 2-24
Page 31Corporate Income Taxes LG2-3
Firms pay out a large portion of their earnings in taxes. For example, in 2012, Walmart had EBT of $24.40 billion. Of this amount, Walmart paid $6.74 billion (over 27 percent of EBT) in taxes. Firms may also defer taxes, e.g., in 2012, Walmart listed a provision for deferred taxes of $1.20 billion. Deferred taxes occur when a company postpones paying taxes on profits earned in a particular period. For example, some expenses, such as those associated with research and development or incurred in mergers, may be written off over a fixed number of years. In these cases, the firm’s current year profits for tax purposes would be lower than the profits computed for accounting purposes. Thus, the company ends up postponing part of its tax liability on this year’s profits to future years.
Congress oversees the U.S. tax code, which determines corporate tax obligations. Corporate taxes can thus change with changes of administration or other changes in the business or public environment. As you might expect, the U.S. tax system is extremely complicated, so we do not attempt to cover it in detail here. However, firms recognize taxes as a major expense item and many financial decisions arise from tax considerations. In this section we provide a general overview of the U.S. corporate tax system.
TABLE 2.3 Corporate Tax Rates as of 2015
The 2015 corporate tax schedule appears in Table 2.3. Note from this table that the U.S. tax structure is progressive, meaning that the larger the income, the higher the taxes assessed.
| EXAMPLE 2-3 | Calculation of Corporate Taxes LG2-3 |
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Indian Point Kennels, Inc., earned $16.5 million taxable income (EBT) in 2015. Use the tax schedule in Table 2.3 to determine the firm’s 2015 tax liability, its average tax rate, and its marginal tax rate.
SOLUTION:
From Table 2.3, the $16.5 million of taxable) income puts Indian Point Kennels in the 38 percent marginal tax bracket. Thus
Note that the base amount is the maximum dollar value listed in the previous tax bracket. In this example, we take the highest dollar value ($15,000,000) in the preceding tax bracket (35 percent). The additional percentage owed results from multiplying the income above and beyond the $15,000,000 (or $1,500,000) by the marginal tax rate (38 percent). The average tax rate for Indian Point Kennels, Inc., comes to:
If Indian Point Kennels earned $1 more of taxable income, it would pay 38 cents (its tax rate of 38 percent) more in taxes. Thus, the firm’s marginal tax rate is 38 percent.
Similar to Problems 2-7, 2-8, 2-25, 2-26, self-test problem 3
Page 32However, corporate tax rates do not increase in any kind of linear way based on this progressive nature: They rise from a low of 15 percent to a high of 39 percent, then drop to 34 percent, rise to 38 percent, and finally drop to 35 percent.
In addition to calculating their tax liability, firms also want to know their average tax rate and marginal tax rate . You can figure the average tax rate as the percentage of each dollar of taxable income that the firm pays in taxes.
From your economics classes, you can probably guess that the firm’s marginal tax rate is the amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns.
Interest and Dividends Received by Corporations Any interest that corporations receive is taxable, although a notable exception arises: Interest on state and local government bonds is exempt from federal taxes. The U.S. tax code allows this exception to encourage corporations to be better community citizens by supporting local governments. Another exception of sorts arises when one corporation owns stock in another corporation. Seventy percent of any dividends received from other corporations is tax exempt. Only the remaining 30 percent is taxed at the receiving corporation’s tax rate.1
Interest and Dividends Paid by Corporations Corporate interest payments appear on the income statement as an expense item, so we deduct interest payments from operating income when the firm calculates taxable income. But any dividends paid by corporations to their shareholders are not tax deductible. This is one factor that encourages managers to finance projects with debt financing rather than to sell more stock. Suppose one firm uses mainly debt financing and another firm, with identical operations, uses mainly equity financing. The equity-financed firm will have very little interest expense to deduct for tax purposes. Thus, it will have higher taxable income and pay more taxes than the debt-financed firm. The debt-financed firm will pay fewer taxes and be able to pay more of its operating income to asset funders, that is, its bondholders and stockholders. So even stockholders prefer that firms finance assets primarily with debt rather than with stock. However, as mentioned earlier, increasing the amount of debt financing of the firm’s assets also increases risks. So these affects must be balanced when selecting the optimal capital structure for a firm. The debt-versus-equity financing issue is called capital structure.
average tax rate The percentage of each dollar of taxable income that the firm pays in taxes.
marginal tax rate The amount of additional taxes a firm must pay out for every additional dollar of taxable income it earns.
| EXAMPLE 2-4 | Corporate Taxes with Interest and Dividend Income LG2-3 |
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In the previous example, suppose that in addition to the $16.5 million of taxable income, Indian Point Kennels, Inc., received $250,000 of interest on state-issued bonds and $500,000 of dividends on common stock it owns in DPH Tree Farm, Inc. How do these items affect Indian Point Kennel’s tax liability, average tax rate, and marginal tax rate?
SOLUTION:
In this case, interest on the state-issued bonds is not taxable and should not be included in taxable income. Further, the first 70 percent of the dividends received from DPH Tree Farm is not taxable. Thus, only 30 percent of the dividends received are taxed, so:
Taxable income = $16,500,000 + (0.3)$500,000 = $16,650,000
Now Indian Point Kennel’s tax liability will be:
Tax liability = $5,150,000 + 0.38($16,650,000 – $15,000,000) = $5,777,000
The $500,000 of dividend income increased Indian Point Kennel’s tax liability by $57,000. Indian Point Kennels, Inc.’s resulting average tax rate is now:
Average tax rate = $5,777,000/$16,650,000 = 34.70%
Finally, if Indian Point Kennels earned $1 more of taxable income, it would still pay 38 cents (based upon its marginal tax rate of 38 percent) more in taxes.
Similar to Problems 2-8, 2-25, 2-26
| EXAMPLE 2-5 | Effect of Debt-versus-Equity Financing on Funders’ Returns LG2-1Page 33 |
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Suppose that you are considering a stock investment in one of two firms (AllDebt, Inc., and AllEquity, Inc.), both of which operate in the same industry and have identical operating incomes of $5 million. AllDebt, Inc., finances its $12 million in assets with $11 million in debt (on which it pays 10 percent interest) and $1 million in equity. AllEquity, Inc., finances its $12 million in assets with no debt and $12 million in equity. Both firms pay 30 percent tax on their taxable income. Calculate the income that each firm has available to pay its debt and stockholders (the firms’ asset funders) and the resulting returns to these asset funders for the two firms.
SOLUTION:
By financing most of its assets with debt and receiving the associated tax benefits from the interest paid on this debt, AllDebt, Inc., is able to pay more of its operating income to the funders of its assets, i.e., its debt holders and stockholders, than AllEquity, Inc.
Similar to Problems 2-19, 2-20
time out!
2-3 What is an income statement?
2-4 When a corporation owns stock in another corporation, what percentage of dividends received on the stock is taxed?
STATEMENT OF CASH FLOWS LG2-4
Income statements and balance sheets are the most common financial documents available to the public. However, managers who make financial decisions need more than these two statements—reports of past performance—on which to base their decisions for today and into the future. A very important distinction between the accounting point of view and the finance point of view is that financial managers and investors are far more interested in actual cash flows than in the backward-looking profit listed on the income statement.
The statement of cash flows is a financial statement that shows the firm’s cash flows over a given period of time. This statement reports the amounts of cash the firm has generated and distributed during a particular time period. The bottom line on the statement of cash flows—the difference between cash Page 34sources and uses—equals the change in cash and marketable securities on the firm’s balance sheet from the previous year’s balance. That is, the statement of cash flows reconciles noncash balance sheet items and income statement items to show changes in the cash and marketable securities account on the balance sheet over the particular analysis period.
To clarify why this statement is so crucial, it helps to understand that figures on an income statement may not represent the actual cash inflows and outflows for a firm during a given period of time. There are two main issues, GAAP accounting principles and noncash income statement entries.
GAAP Accounting Principles
Company accountants must prepare firm income statements following GAAP principles. GAAP procedures require that the firm recognize revenue at the time of sale. But sometimes the company receives the cash before or after the time of sale. Likewise, GAAP counsels the firm to show production and other expenses on the income statement as the sales of those goods take place. So production and other expenses associated with a particular product’s sale appear on the income statement (for example, cost of goods sold and depreciation) only when that product sells. Of course, just as with revenue recognition, actual cash outflows incurred with production may occur at a very different point in time—usually much earlier than GAAP principles allow the firm to formally recognize the expenses.
Noncash Income Statement Entries
Further, income statements contain several noncash entries, the largest of which is depreciation. Depreciation attempts to capture the noncash expense incurred as fixed assets deteriorate from the time of purchase to the point when those assets must be replaced.
Let’s illustrate the effect of depreciation: Suppose a firm purchases a machine for $100,000. The machine has an expected life of five years and at the end of those five years, the machine will have no expected salvage value. The firm incurs a $100,000 cash outflow at the time of purchase. But the entire $100,000 does not appear on the income statement in the year that the firm purchases the machine—in accounting terms, the machine is not expensed in the year of purchase. Rather, if the firm’s accounting department uses the straight-line depreciation method, it deducts only $100,000/5, or $20,000, each year as an expense. This $20,000 equipment expense is not a cash outflow for the firm. The person in charge of buying the machine knows that the cash flow occurred at the time of purchase—and it totaled $100,000 rather than $20,000.
In conclusion, finance professionals know that the firm needs cash, not accounting profits, to pay the firm’s obligations as they come due, to fund the firm’s operations and growth, and to compensate the firm’s ultimate owners: its shareholders.
Sources and Uses of Cash LG2-5
In general, some activities increase cash (cash sources) and some decrease cash (cash uses). Figure 2.3 classifies the firm’s basic cash sources and uses. Cash sources include decreasing noncash assets or increasing liabilities (or equity). For example, a drop in accounts receivable means that the firm has collected cash from its credit sales—a cash source. Likewise, if a firm sells new common stock, the firm has used primary markets to raise cash. In contrast, a firm uses cash when it increases non-cash assets (buying inventory) or decreases a liability (paying off a bank loan). The statement of cash flows separates these cash flows into three categories or sections:
1. Cash flows from operating activities.
2. Cash flows from investing activities.
3. Cash flows from financing activities.
4. Net change in cash and marketable securities.
The basic setup of a statement of cash flows is shown in Figure 2.4 and a more detailed statement of cash flows for DPH Tree Farm for the year ending December 31, 2015, appears as Table 2.4.
Cash flows from operations (Section A in Figure 2.4 and Table 2.4) are those cash inflows and outflows that result directly from producing and selling the firm’s products. These cash flows include:
• Net income (adding back depreciation,2 a noncash expense item that is included in net income).
• Working capital accounts other than cash and operations-related short-term debt.
statement of cash flows Financial statement that shows the firm’s cash flows over a period of time.
cash flows from operations Cash flows that are the direct result of the production and sale of the firm’s products.
cash flows from investing activities Cash flows associated with the purchase or sale of fixed or other long-term assets.
cash flows from financing activities Cash flows that result from debt and equity financing transactions.
FIGURE 2.3 Sources and Uses of Cash
Page 35
FIGURE 2.4 The Statement of Cash Flows
Most finance professionals consider this top section of the statement of cash flows to be the most important. It shows quickly and compactly the firm’s cash flows generated by and used for the production process. For example, DPH Tree Farm, Inc., generated $97 million in cash flows from its 2015 production. That is, producing and selling the firm’s product resulted in a net cash inflow for the firm. Managers and investors look for positive cash flows from operations as a sign of a successful firm—positive cash flows from the firm’s operations is precisely what gives the firm value. Unless the firm has a stable, healthy pattern in its cash flows from operations, it is not financially healthy no matter what its level of cash flow from investing activities or cash flows from financing activities.
Cash flows from investing activities (Section B in Figure 2.4 and Table 2.4) are cash flows associated with buying or selling of fixed or other long-term assets. This section of the statement of cash flows shows cash inflows and outflows from long-term investing activities—most significantly the firm’s investment in fixed assets. For example, DPH Tree Farm, Inc., used $68 million in cash to purchase fixed and other long-term assets in 2015. DPH funded this $68 million cash outflow with the $97 million cash surplus DPH Tree Farm produced from its operations.
TABLE 2.4 Statement of Cash Flows for DPH Tree Farm, Inc.
Cash flows from financing activities (Section C in Figure 2.4 and Table 2.4) are cash flows that result from debt and equity financing transactions. These include raising cash by:
• Issuing short-term debt
• Issuing long-term debt
• Issuing stock
Page 36
DPH Tree Farm reported net income of 90 million yet reported a net change in cash and marketable securities of -1 million on its statement of cash flows.
or using cash to:
• Pay dividends
• Pay off debt
• Buy back stock
In 2015, DPH Tree Farm, Inc.’s, financing activities produced a net cash outflow of $30 million. As we saw with cash flows from financing activities, this $30 million cash outflow was funded (at least partially) with the $97 million cash surplus DPH Tree Farm produced from its operations. Managers, investors, and analysts normally expect the cash flows from financing activities to include small amounts of net borrowing along with dividend payments. If, however, a firm is going through a major period of expansion, net borrowing could reasonably be much higher.
Net change in cash and marketable securities (Section D in Figure 2.4 and Table 2.4), the bottom line of the statement of cash flows, shows the sum of cash flows from operations, investing activities, and financing activities. This sum will reconcile to the net change in cash and marketable securities account on the balance sheet over the period of analysis. For example, the bottom line of the statement of cash flows for DPH Tree Farm is −$1 million. This is also the change in the cash and marketable securities account on the balance sheet (inTable 2.1) between 2014 and 2015 ($24 million −$25 million = −$1 million). In this case, the firm’s operating, investing, and financing activities combined to produce a net drain on the firm’s cash during 2015—cash outflows were greater than cash inflows, largely because of the $68 million investment in long-term and fixed assets. Of course, when the bottom line is positive, a firm’s cash inflows exceed cash outflows for the period.
Even though a company may report a large amount of net income on its income statement during a year, the firm may actually receive a positive, negative, or zero amount of cash. For example, DPH Tree Farm, Inc., reported net income of $90 million on its income statement (inTable 2.2), yet reported a net change in cash and marketable securities of −$1 million on its statement of cash flows (in Table 2.4). Accounting rules under GAAP create this sense of discord: Net income is the result of accounting rules, or GAAP, that do not necessarily reflect the firm’s cash flows. While the income statement shows a firm’s accounting-based income, the statement of cash flows more often reflects reality today and is thus more important to managers and investors as they seek to answer such important questions as:
• Does the firm generate sufficient cash to pay its obligations, thus avoiding financial distress?
• Does the firm generate sufficient cash to purchase assets needed for sustained growth?
• Does the firm generate sufficient cash to pay down its outstanding debt obligations?
FREE CASH FLOW
The statement of cash flows measures net cash flow as net income plus noncash adjustments. However, to maintain cash flows over time, firms must continually replace working capital and fixed assets and develop new products. Thus, firm managers cannot use the available cash flows any way they please. Specifically, the value of a firm’s operations depends on the future expected free cash flows , defined as after-tax operating profit minus the amount of new investment in working capital, fixed assets, and the development of new products. Thus, free cash flow represents the cash that is actually available for distribution to the investors in the firm—the firm’s debt holders and stockholders—after the investments that are necessary to sustain the firm’s ongoing operations are made.
To calculate free cash flow (FCF), we use the mathematical equation that appears below:
Notice from this equation that free cash flow merges information from the income statement (performance) with information from the balance sheet (resources used to produce performance).
To calculate free cash flow, we start with operating cash flow. Firms generate operating cash flow (OCF) after they have paid necessary operating expenses and taxes. This net operating profit after taxes (NOPAT) is the net profit a firm earns after Page 37taxes, but before any financing costs. It is the profit available for debt holders and stockholders if the firm does not replace existing or invest in new working capital or fixed assets. Depreciation, a noncash charge, is added back to NOPAT to determine total OCF. We add other relevant noncash charges, such as amortization and depletion, back as well. Firms either buy physical assets or earmark funds for eventual equipment replacement to sustain firm operations; this is called investment in operating capital (IOC). In accounting terms, IOC includes the firm’s gross investments (or changes) in fixed assets, current assets, and spontaneous current liabilities (such as accounts payable and accrued wages). Thus, free cash flow measures how well managers utilize the resources of the company to increase firm performance and, thus, enhance shareholder wealth.
net change in cash and marketable securities The sum of the cash flows from operations, investing activities, and financing activities.
free cash flows The cash that is actually available for distribution to the investors in the firm after the investments that are necessary to sustain the firm’s ongoing operations are made.
net operating profit after taxes (NOPAT) Net profit a firm earns after taxes but before any financing costs.
Like the bottom line shown on the statement of cash flows, the level of free cash flow can be positive, zero, or negative. A positive free cash flow value means that the firm may distribute funds to its investors (debt holders and stockholders.) When the firm’s free cash flows come in as zero or negative, however, the firm’s operations produce no cash flows available for investors. Of course, if free cash flow is negative because operating cash flow is negative, investors are likely to take up the issue with the firm’s management. Negative free cash flows as a result of negative operating cash flows generally indicate that the firm is experiencing operating or managerial problems. A firm with positive operating cash flows, but negative free cash flows, however, is not necessarily a poorly managed firm. Firms that invest heavily in operating capital to support growth often have positive operating cash flows but negative free cash flows. But in this case, the negative free cash flow will likely result in growing future profits.
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2-5 What is a statement of cash flows?
2-6 What are the main sections on the statement of cash flows?
| EXAMPLE 2-6 | Calculating Free Cash Flow LG2-5 |
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From Tables 2.1 and 2.2, in 2015, DPH Tree Farm, Inc., had EBIT of $152 million, a tax rate of 33.82 percent ($46m/$136m), and depreciation expense of $13 million. Therefore, DPH Tree Farm’s operating cash flow was:
DPH Tree Farm’s gross fixed assets increased by $68 million between 2014 and 2015. The firm’s current assets increased by $15 million and spontaneous current liabilities increased by $10 million ($5 million in accrued wages and taxes and $5 million in accounts payable). Therefore, DPH’s investment in operating capital for 2015 was:
SOLUTION:
In other words, in 2015, DPH Tree Farm, Inc., had cash flows of $41 million available to pay its stockholders and debt holders.
Similar to Problems 2-11, 2-12, self-test problem 4
Page 38statement of retained earnings Financial statement that reconciles net income earned during a given period and any cash dividends paid with the change in retained earnings over the period.
earnings management The process of controlling a firm’s earnings.
Sarbanes-Oxley Act of 2002 Requires that a firm’s senior management must sign off on the financial statements of the firm, certifying the statements as accurate and representative of the firm’s financial condition during the period covered.
STATEMENT OF RETAINED EARNINGS
The statement of retained earnings provides additional details about changes in retained earnings during a reporting period. This financial statement reconciles net income earned during a given period and any cash dividends paid within that period on one side with the change in retained earnings between the beginning and ending of the period on the other. Table 2.5 presents DPH Tree Farm, Inc.’s, statement of retained earnings as of December 31, 2015. The statement shows that DPH Tree Farms brought in a net income of $90 million during 2015. The firm paid out $10 million in dividends to preferred stockholders and another $25 million to common stockholders. The firm then had $55 million to reinvest back into the firm, which shows as an increase in retained earnings. Thus, the retained earnings account on the balance sheet (Table 2.1) increased from $155 million at year-end 2014 to $210 million at year-end 2015.
TABLE 2.5 Statement of Retained Earnings for DPH Tree Farm, Inc.
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2-7 What is a statement of retained earnings?
2-8 If, during a given period, a firm pays out more in dividends than it has net income, what happens to the firm’s retained earnings?
“INCREASES IN RETAINED EARNINGS OCCUR NOT JUST BECAUSE A FIRM HAS NET INCOME, BUT ALSO BECAUSE THE FIRM’S COMMON STOCKHOLDERS AGREE TO LET MANAGEMENT REINVEST NET INCOME BACK INTO THE FIRM RATHER THAN PAY IT OUT AS DIVIDENDS.”
Increases in retained earnings occur not just because a firm has net income, but also because the firm’s common stockholders agree to let management reinvest net income back into the firm rather than pay it out as dividends. If the shareholders disagreed with the firm’s policy, they would simply sell their shares. Reinvesting earnings is less expensive than raising capital from outside sources (debt and equity markets). Further, reinvesting net income into retained earnings allows the firm to grow by providing additional funds that can be spent on plant and equipment, inventory, and other assets needed to generate even more profit. So, retained earnings represent a claim against all of the firm’s assets and not against a particular asset.
CAUTIONS IN INTERPRETING FINANCIAL STATEMENTS LG2-6
As we mentioned earlier in the chapter, firms must prepare their financial statements according to GAAP. GAAP provides a common set of standards intended to produce objective and precise financial statements. But recall also that managers have significant discretion over their reported earnings. Managers and financial analysts have recognized for years that firms use considerable latitude in using accounting rules to manage their reported earnings in a wide variety of contexts. Indeed, within the GAAP framework, firms can “smooth” earnings. That is, firms often take steps to over- or understate earnings at various times. Managers may choose to smooth earnings to show investors that firm assets are growing steadily. Similarly, one firm may be using straight-line depreciation for its fixed assets, while another is using a modified accelerated cost recovery method (MACRS), which causes depreciation to accrue quickly. If the firm uses MACRS accounting methods, its managers write fixed asset values down quickly; assets will thus have lower book values than if the firm used straight-line depreciation methods.
| EXAMPLE 2-7 | Statement of Retained Earnings LG2-1Page 39 |
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Indian Point Kennels, Inc., earned net income in 2015 of $10.78 million. The firm paid out $1 million in cash dividends to its preferred stockholders and $2.5 million in cash dividends to its common stockholders. The firm ended 2014 with $135.75 million in retained earnings. Construct a statement of retained earnings to calculate the year-end 2015 balance of retained earnings.
SOLUTION:
The statement of retained earnings for 2015 is as follows:
Similar to Problems 2-13, 2-14, self-test problem 1
This process of controlling a firm’s earnings is called earnings management . At the extreme, earnings management has resulted in some widely reported accounting scandals involving Enron, Merck, WorldCom, and other major U.S. corporations that tried to artificially influence their earnings by manipulating accounting rules. Congress responded to the spate of corporate scandals that emerged after 2001 with the Sarbanes-Oxley Act , passed in June 2002. Sarbanes-Oxley requires public companies to ensure that their corporate boards’ audit committees have considerable experience applying generally accepted accounting principles (GAAP) for financial statements. The act also requires that a firm’s senior management must sign off on the financial statements of the firm, certifying the statements as accurate and representative of the firm’s financial condition during the period covered. If a firm’s board of directors or senior managers fail to comply with Sarbanes-Oxley (SOX), the firm may be delisted from stock exchanges.
As illustrated in the Finance at Work reading, American Apparel failed to file quarterly and annual reports in 2010 and 2011 in a timely manner. As a result, the firm’s common stock became subject to delisting. Congress’s goal in passing SOX was to prevent deceptive accounting and management practices and to bring stability to jittery stock markets battered in 2002 by accounting and managerial scandals that cost employees their life savings and harmed many innocent shareholders as well. See also the discussion of the role of ethics in finance in Chapter 1.
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2-9 What is earnings management?
Page 40finance at work //: markets
American Apparel Receives NYSE AMEX Delisting Letters Relating to Late Filing of 10-Qs and 10-K
American Apparel (APP), a vertically integrated manufacturer, distributor, and retailer of branded fashion basic apparel, is an extreme example of a firm that failed to comply with SEC and Sarbanes-Oxley Act requirements three times over a period of less than one year. The result each time was a notice of delisting sent to the firm by the SEC. APP was eventually able to address the issues and is still an exchange-listed company.
On May 19, 2010, APP announced its preliminary first quarter 2010 financial results. In the announcement, American Apparel stated that, “While the financial results reported herein are preliminary and subject to adjustment, American Apparel is working to complete the preparation and review of the financial statements, and related disclosures, for the quarter ended March 31, 2010. The company is still reviewing certain items, including retail store impairment, inventory reserves and the provision for income taxes. Until the review of these items is completed, the company is not in a position to complete the preparation of the financial statements and certain related information required to be included in its Quarterly Report on Form 10-Q for the quarter ended March 31, 2010 . . . No assurances can be given as to when the Form 10-Q will ultimately be filed, or that the financial statements contained therein will not differ materially from those presented in this preliminary earnings release” (Press Release, May 19, 2010).
On May 18, 2010, APP received a letter from the NYSE Amex stating that the company’s failure to timely file the Form 10-Q is a material violation of the company’s listing agreement with the Exchange. The letter stated that by June 1, 2010, the company must submit a plan to the Exchange outlining how it would bring the company into compliance by no later than August 16, 2010. APP submitted their plan of compliance and on June 23, 2010, the Exchange announced the plan as accepted. APP filed its first quarter 2010 10-Q on August 17, 2010.
This was not the end, however, as APP had yet to file its second quarter 10-Q. On August 23, 2010, APP announced that it received a second letter from the NYSE Amex stating that the company’s failure to timely file the Form 10-Q is a material violation of the company’s listing agreement with the Exchange. APP stated that the delay in filing had been caused by the resignation of Deloitte & Touche, APP’s auditor. Deloitte said it found material weaknesses in internal controls over financial reporting and that, consequently, the company’s 2009 financial statements may not be reliable. Subsequently, the company was again threatened with being delisted for failing to submit a quarterly earnings report. This time the Exchange accepted APP’s plan to file the second quarter 10-Q no later than November 15, 2010. APP filed its second quarter 2010 10-Q on November 1, 2010.
Still facing trouble, on March 22, 2011, APP announced that it could not meet an SEC deadline to file its annual report. The company received a third notice of delisting in less than a year. In this case, because of the issues that arose regarding the 2009 annual report, the company was in violation for both its 2009 and 2010 annual reports. The letter from the Exchange stated that the filing of a complete 2009 10-K, which included audited financials, was a condition for the company’s continued listing on the Exchange. APP filed an amended 2009 10-K on February 7, 2011, and its 2010 10-K on March 31, with amendments on May 2, May 3, and May 17.
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Key Words to Search for Updates: Sarbanes-Oxley Act of 2002, stock delistings, 10Q filing, 10K filing
Page 41
Your Turn…
Questions
1. List and describe the four major financial statements. ( LG2-1 )
2. On which of the four major financial statements (balance sheet, income statement, statement of cash flows, or statement of retained earnings) would you find the following items? ( LG2-1 )
a. Earnings before taxes.
b. Net plant and equipment.
c. Increase in fixed assets.
d. Gross profits.
e. Balance of retained earnings, December 31, 20xx.
f. Common stock and paid-in surplus.
g. Net cash flow from investing activities.
h. Accrued wages and taxes.
i. Increase in inventory.
3. What is the difference between current liabilities and long-term debt? ( LG2-1 )
4. How does the choice of accounting method used to record fixed asset depreciation affect management of the balance sheet? ( LG2-1 )
5. What are the costs and benefits of holding liquid securities on a firm’s balance sheet? ( LG2-1 )
6. Why can the book value and market value of a firm differ? ( LG2-1 )
7. From a firm manager’s or investor’s point of view, which is more important—the book value of a firm or the market value of the firm? ( LG2-2 )
8. What do we mean by a progressive tax structure? ( LG2-3 )
9. What is the difference between an average tax rate and a marginal tax rate? ( LG2-3 )
10. How does the payment of interest on debt affect the amount of taxes the firm must pay? ( LG2-3 )
11. The income statement is prepared using GAAP. How does this affect the reported revenue and expense measures listed on the balance sheet? ( LG2-4 )
12. Why do financial managers and investors find cash flows to be more important than accounting profit? ( LG2-4 )
Page 4213. Which of the following activities result in an increase (decrease) in a firm’s cash? ( LG2-5 )
a. Decrease fixed assets.
b. Decrease accounts payable.
c. Pay dividends.
d. Sell common stock.
e. Decrease accounts receivable.
f. Increase notes payable.
14. What is the difference between cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities? ( LG2-5 )
15. What are free cash flows for a firm? What does it mean when a firm’s free cash flow is negative? ( LG2-5 )
16. What is earnings management? ( LG2-6 )
17. What does the Sarbanes-Oxley Act require of firm managers? ( LG2-6 )
Problems
BASIC PROBLEMS
2-1 Balance Sheet You are evaluating the balance sheet for Goodman’s Bees Corporation. From the balance sheet you find the following balances: cash and marketable securities = $400,000, accounts receivable = $1,200,000, inventory = $2,100,000, accrued wages and taxes = $500,000, accounts payable = $800,000, and notes payable = $600,000. Calculate Goodman Bees’ net working capital. ( LG2-1 )
2-2 Balance Sheet Casello Mowing & Landscaping’s year-end 2015 balance sheet lists current assets of $435,200, fixed assets of $550,800, current liabilities of $416,600, and long-term debt of $314,500. Calculate Casello’s total stockholders’ equity. ( LG2-1 )
2-3 Income Statement The Fitness Studio, Inc.’s, 2015 income statement lists the following income and expenses: EBIT = $538,000, interest expense = $63,000, and net income = $435,000. Calculate the 2015 taxes reported on the income statement. ( LG2-1 )
2-4 Income Statement The Fitness Studio, Inc.’s, 2015 income statement lists the following income and expenses: EBIT = $773,500, interest expense = $100,000, and taxes = $234,500. The firm has no preferred stock outstanding and 100,000 shares of common stock outstanding. Calculate the 2015 earnings per share. ( LG2-1 )
2-5 Income Statement Consider a firm with an EBIT of $850,000. The firm finances its assets with $2,500,000 debt (costing 7.5 percent) and 400,000 shares of stock selling at $5.00 per share. To reduce the firm’s risk associated with this financial leverage, the firm is considering reducing its debt by $1,000,000 by selling an additional 200,000 shares of stock. The firm is in the 40 percent tax bracket. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $850,000. Calculate the change in the firm’s EPS from this change in capital structure. ( LG2-1 )
2-6 Income Statement Consider a firm with an EBIT of $550,000. The firm finances its assets with $1,000,000 debt (costing 5.5 percent) and 200,000 shares of stock selling at $12.00 per share. The firm is considering increasing its debt by $900,000, using the proceeds to buy back 75,000 shares of stock. The firm is in the 40 percent tax bracket. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $550,000. Calculate the change in the firm’s EPS from this change in capital structure. ( LG2-1 )
2-7 Corporate Taxes Oakdale Fashions, Inc., had $245,000 in 2015 taxable income. Using the tax schedule in Table 2.3, calculate the company’s 2015 income taxes. What is the average tax rate? What is the marginal tax rate? ( LG2-3 )
2-8 Corporate Taxes Hunt Taxidermy, Inc., is concerned about the taxes paid by the company in 2015. In addition to $42.4 million of taxable income, the firm received $2,975,000 of interest on state-issued bonds and $1,000,000 of dividends on common stock it owns in Oakdale Fashions, Inc. Calculate Hunt Taxidermy’s tax liability, average tax rate, and marginal tax rate. ( LG2-3 )
Page 432-9 Statement of Cash Flows Ramakrishnan, Inc., reported 2015 net income of $15 million and depreciation of $2,650,000. The top part of Ramakrishnan, Inc.’s 2015 and 2014 balance sheets is reproduced below (in millions of dollars).
Calculate the 2015 net cash flow from operating activities for Ramakrishnan, Inc. ( LG2-4 )
2-10 Statement of Cash Flows In 2015, Usher Sports Shop had cash flows from investing activities of $−4,364,000 and cash flows from financing activities of $−5,880,000. The balance in the firm’s cash account was $1,615,000 at the beginning of 2015 and $1,742,000 at the end of the year. Calculate Usher Sports Shop’s cash flow from operations for 2015. ( LG2-4 )
2-11 Free Cash Flow You are considering an investment in Fields and Struthers, Inc., and want to evaluate the firm’s free cash flow. From the income statement, you see that Fields and Struthers earned an EBIT of $62 million, had a tax rate of 30 percent, and its depreciation expense was $5 million. Fields and Struthers’ NOPAT gross fixed assets increased by $32 million from 2014 and 2015. The firm’s current assets increased by $20 million and spontaneous current liabilities increased by $12 million. Calculate Fields and Struthers’ NOPAT operating cash flow, investment in operating capital, and free cash flow for 2015. ( LG2-5 )
2-12 Free Cash Flow Tater and Pepper Corp. reported free cash flows for 2015 of $39.1 million and investment in operating capital of $22.1 million. Tater and Pepper incurred $13.6 million in depreciation expense and paid $28.9 million in taxes on EBIT in 2015. Calculate Tater and Pepper’s 2015 EBIT. ( LG2-5 )
2-13 Statement of Retained Earnings Mr. Husker’s Tuxedos Corp. began the year 2015 with $256 million in retained earnings. The firm earned net income of $33 million in 2015 and paid dividends of $5 million to its preferred stockholders and $10 million to its common stockholders. What is the year-end 2015 balance in retained earnings for Mr. Husker’s Tuxedos? ( LG2-1 )
2-14 Statement of Retained Earnings Use the following information to find dividends paid to common stockholders during 2015. ( LG2-1 )
INTERMEDIATE PROBLEMS
2-15 Balance Sheet Brenda’s Bar and Grill has total assets of $15 million, of which $5 million are current assets. Cash makes up 10 percent of the current assets and accounts receivable makes up another 40 percent of current assets. Brenda’s gross plant and equipment has a book value of $11.5 million and other long-term assets have a book value of $500,000. Using this information, what is the balance of inventory and the balance of depreciation on Brenda’s Bar and Grill’s balance sheet? ( LG2-1 )
2-16 Balance Sheet Glen’s Tobacco Shop has total assets of $91.8 million. Fifty percent of these assets are financed with debt of which $28.9 million is current liabilities. The firm Page 44has no preferred stock but the balance in common stock and paid-in surplus is $20.4 million. Using this information, what is the balance for long-term debt and retained earnings on Glen’s Tobacco Shop’s balance sheet? ( LG2-1 )
2-17 Market Value versus Book Value Muffin’s Masonry, Inc.’s, balance sheet lists net fixed assets as $14 million. The fixed assets could currently be sold for $19 million. Muffin’s current balance sheet shows current liabilities of $5.5 million and net working capital of $4.5 million. If all the current accounts were liquidated today, the company would receive $7.25 million cash after paying the $5.5 million in current liabilities. What is the book value of Muffin’s Masonry’s assets today? What is the market value of these assets? ( LG2-2 )
2-18 Market Value versus Book Value Ava’s SpinBall Corp. lists fixed assets of $12 million on its balance sheet. The firm’s fixed assets have recently been appraised at $16 million. Ava’s SpinBall Corp.’s balance sheet also lists current assets at $5 million. Current assets were appraised at $6 million. Current liabilities’ book and market values stand at $3 million and the firm’s book and market values of long-term debt are $7 million. Calculate the book and market values of the firm’s stockholders’ equity. Construct the book value and market value balance sheets for Ava’s SpinBall Corp. ( LG2-2 )
2-19 Debt versus Equity Financing You are considering a stock investment in one of two firms (NoEquity, Inc., and NoDebt, Inc.), both of which operate in the same industry and have identical operating income of $32.5 million. NoEquity, Inc., finances its $65 million in assets with $64 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. NoDebt, Inc., finances its $65 million in assets with no debt and $65 million in equity. Both firms pay a tax rate of 30 percent on their taxable income. Calculate the net income and return on assets for the two firms. ( LG2-1 )
2-20 Debt versus Equity Financing You are considering a stock investment in one of two firms (AllDebt, Inc., and AllEquity, Inc.), both of which operate in the same industry and have identical operating income of $12.5 million. AllDebt, Inc., finances its $25 million in assets with $24 million in debt (on which it pays 10 percent interest annually) and $1 million in equity. AllEquity, Inc., finances its $25 million in assets with no debt and $25 million in equity. Both firms pay a tax rate of 30 percent on their taxable income. Calculate the income available to pay the asset funders (the debt holders and stockholders) and resulting return on assets for the two firms. ( LG2-1 )
2-21 Income Statement You have been given the following information for Corky’s Bedding Corp.:
a. Net sales = $11,250,000.
b. Cost of goods sold = $7,500,000.
c. Other operating expenses = $250,000.
d. Addition to retained earnings = $1,000,000.
e. Dividends paid to preferred and common stockholders = $495,000.
f. Interest expense = $850,000.
The firm’s tax rate is 35 percent. Calculate the depreciation expense for Corky’s Bedding Corp. ( LG2-1 )
2-22 Income Statement You have been given the following information for Moore’s Honey-Bee Corp.:
a. Net sales = $32,000,000.
b. Gross profit = $18,700,000.
c. Other operating expenses = $2,500,000.
d. Addition to retained earnings = $4,700,000.
e. Dividends paid to preferred and common stockholders = $2,900,000.
f. Depreciation expense = $2,800,000.
Page 45The firm’s tax rate is 35 percent. Calculate the cost of goods sold and the interest expense for Moore’s HoneyBee Corp. ( LG2-1 )
2-23 Income Statement Consider a firm with an EBIT of $1,000,000. The firm finances its assets with $4,500,000 debt (costing 8 percent) and 200,000 shares of stock selling at $16.00 per share. To reduce risk associated with this financial leverage, the firm is considering reducing its debt by $2,500,000 by selling additional shares of stock. The firm is in the 40 percent tax bracket. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $1,000,000. Calculate the change in the firm’s EPS from this change in capital structure. ( LG2-1 )
2-24 Income Statement Consider a firm with an EBIT of $10,500,000. The firm finances its assets with $50,000,000 debt (costing 6.5 percent) and 10,000,000 shares of stock selling at $10.00 per share. The firm is considering increasing its debt by $25,000,000, using the proceeds to buy back shares of stock. The firm is in the 40 percent tax bracket. The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at $10,500,000. Calculate the change in the firm’s EPS from this change in capital structure. ( LG2-1 )
2-25 Corporate Taxes The Dakota Corporation had a 2015 taxable income of $33,365,000 from operations after all operating costs but before (1) interest charges of $8,500,000; (2) dividends received of $750,000; (3) dividends paid of $5,250,000; and (4) income taxes. ( LG2-3 )
a. Use the tax schedule in Table 2.3 to calculate Dakota’s income tax liability.
b. What are Dakota’s average and marginal tax rates on taxable income?
2-26 Corporate Taxes Suppose that in addition to $17.85 million of taxable income, Texas Taco, Inc., received $1,105,000 of interest on state-issued bonds and $760,000 of dividends on common stock it owns in Arizona Taco, Inc. ( LG2-3 )
a. Use the tax schedule in Table 2.3 to calculate Texas Taco’s income tax liability.
b. What are Texas Taco’s average and marginal tax rates on taxable income?
2-27 Statement of Cash Flows Use the balance sheet and income statement below to construct a statement of cash flows for Clancy’s Dog Biscuit Corporation. ( LG2-5 )
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2-28 Statement of Cash Flows Use the balance sheet and income statement below to construct a statement of cash flows for Valium’s Medical Supply Corporation. ( LG2-5 )
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2-29 Statement of Cash Flows Chris’s Outdoor Furniture, Inc., has net cash flows from operating activities for the last year of $340 million. The income statement shows that net income is $315 million and depreciation expense is $46 million. During the year, the change in inventory on the balance sheet was $38 million, change in accrued wages and taxes was $15 million, and change in accounts payable was $20 million. At the beginning of the year, the balance of accounts receivable was $50 million. Calculate the end-of-year balance for accounts receivable. ( LG2-5 )
2-30 Statement of Cash Flows Dogs 4 U Corporation has net cash flow from financing activities for the last year of $34 million. The company paid $178 million in dividends last year. During the year, the change in notes payable on the balance sheet was $39 million and change in common and preferred stock was $0. The end-of-year balance for long-term debt was $315 million. Calculate the beginning-of-year balance for long-term debt. ( LG2-5 )
2-31 Free Cash Flow The 2015 income statement for Duffy’s Pest Control shows that depreciation expense was $197 million, EBIT was $494 million, and the tax rate was 30 percent. At the beginning of the year, the balance of gross fixed assets was $1,562 million and net operating working capital was $417 million. At the end of the year, gross fixed assets was $1,803 million. Duffy’s free cash flow for the year was $424 million. Calculate the end-of-year balance for net operating working capital. ( LG2-5 )
2-32 Free Cash Flow The 2015 income statement for Egyptian Noise Blasters shows that depreciation expense is $85 million, NOPAT is $246 million. At the end of the year, the balance of gross fixed assets was $655 million. The change in net operating working capital during the year was $73 million. Egyptian’s free cash flow for the year was $190 million. Calculate the beginning-of-year balance for gross fixed assets. ( LG2-5 )
Page 482-33 Statement of Retained Earnings Thelma and Louie, Inc., started the year with a balance of retained earnings of $543 million and ended the year with retained earnings of $589 million. The company paid dividends of $35 million to the preferred stockholders and $88 million to common stockholders. Calculate Thelma and Louie’s net income for the year. ( LG2-1 )
2-34 Statement of Retained Earnings Jamaica Tours, Inc., started the year with a balance of retained earnings of $1,780 million. The company reported net income for the year of $284 million and paid dividends of $17 million to the preferred stockholders and $59 million to common stockholders. Calculate Jamaica Tour’s end-of-year balance in retained earnings. ( LG2-1 )
ADVANCED PROBLEMS
2-35 Income Statement Listed below is the 2015 income statement for Tom and Sue Travels, Inc.
The CEO of Tom and Sue’s wants the company to earn a net income of $2.250 million in 2016. Cost of goods sold is expected to be 60 percent of net sales, depreciation and other operating expenses are not expected to change, interest expense is expected to increase to $1.050 million, and the firm’s tax rate will be 30 percent. Calculate the net sales needed to produce net income of $2.250 million. ( LG2-1 )
2-36 Income Statement You have been given the following information for PattyCake’s Athletic Wear Corp. for the year 2015:
a. Net sales = $38,250,000.
b. Cost of goods sold = $22,070,000.
c. Other operating expenses = $5,300,000.
d. Addition to retained earnings = $1,195,500.
e. Dividends paid to preferred and common stockholders = $1,912,000.
f. Interest expense = $1,785,000.
g. The firm’s tax rate is 30 percent.
In 2016:
h. Net sales are expected to increase by $9.75 million.
i. Cost of goods sold is expected to be 60 percent of net sales.
j. Depreciation and other operating expenses are expected to be the same as in 2015.
Page 49k. Interest expense is expected to be $2,004,286.
l. The tax rate is expected to be 30 percent of EBT.
m. Dividends paid to preferred and common stockholders will not change.
Calculate the addition to retained earnings expected in 2016. ( LG2-1 )
2-37 Free Cash Flow Rebecky’s Flowers 4U, Inc., had free cash flows during 2015 of $43 million, NOPAT of $85 million, and depreciation of $14 million. Using this information, fill in the blanks on Rebecky’s balance sheet below. ( LG2-5 )
2-38 Free Cash Flow Vinny’s Overhead Construction had free cash flow during 2015 of $25.4 million. The change in gross fixed assets on Vinny’s balance sheet during 2015 was $7.0 million and the change in net operating working capital was $8.4 million. Using this information, fill in the blanks on Vinny’s income statement below. ( LG2-5 )
1This tax code provision prevents or reduces any triple taxation that could occur: Income could be taxed at three levels: (1) on the income from the dividend-paying firm, (2) as income for the dividend-receiving firm, and (3) finally, on the personal income of stockholders who receive dividends.
2 Any other noncash expense (e.g., amortization) would also be added back to net income and any noncash revenue would be subtracted.
